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The Financing vs. Wait-and-See Channels: An Illustration

To fix ideas, it is useful to start with a graphical illustration of the channels at work in our empirical investigation. To this end, Figure 2 (left panel) shows a downward-sloping relationship between investment and net leverage, consistent with the presence of financial market imperfections—a departure from the frictionless world in Modigliani and Miller (1958). Specifically, owing to agency costs from asymmetric information, firms with higher net leverage face more costly external financing, and invest less. In response to an external financing/volatility shock, the existing empirical literature has indicated that (on average and

9 Before McLean and Zhao (2014), most of the literature treats this sensitivity to be time-invariant; they instead use U.S. data to show that such sensitivity varies over time with the business cycles. Our work further specifies that interest rates and uncertainty are two crucial determinants. Related work includes Baum and others (2009 and 2010) from which we depart by exploiting country heterogeneity among emerging market firms (as in Love and Zicchino, 2006; Love, 2003; and Magud and Sosa, 2015).

in the aggregate) firms cut their capital expenditures. This is depicted as a parallel downward shift in the investment schedule. We argue, however, that the shift is not necessarily parallel in that firms may respond differently depending on their existing leverage, as illustrated in Figure 2 (right panel). The latter results from the fact that increases in external financing costs in response to a shock are generally not homogeneous over the cross-section of firms.

Firms that are more leveraged will incur a greater increase in the cost of external finance upon an increase in interest-rate/volatility and thus cut investment by relatively more.

Moreover, we also explore the existence of differential responses along the dimension of country fundamentals.

Figure 2. Cross-sectional responses of investment to higher interest rates

Notes: The left panel illustrates the average response of corporate investment to higher interest rates in the presence of financial frictions. The right panel adds the rotation of the investment schedule resulting from firms with heterogeneous leverage responding differently to the shock.

Figure 3 presents the investment schedule as a function of a firm’s cash flow, where the positive slope can also result from the presence of financial market imperfections. We interpret this slope as the marginal propensity to invest (MPI). As before, the average response to a negative financial shock is represented by a parallel downward shift in the investment schedule, yet the direction of the rotation varies with the channel at work. For an interest-rate shock, the slope increases. Firms with more internal funds (cash flow) have their average costs of capital affected relatively less by this shock and firms’ average marginal propensity to invest increases.

For an uncertainty shock, however, the response is more complex. As before, there is a financing channel through firms’ external borrowing costs. Higher volatility can lead to higher default risk, which exacerbates the deadweight losses associated with financial

frictions. Thus, those firms with more cash flow reduce capital expenditures less when facing an uncertainty shock. In other words, and as with interest-rate shocks, the financing channel of uncertainty increases firms’ average marginal propensity to invest (the investment slope to cash flows increases). However, there is an additional channel through which uncertainty, despite having qualitatively similar effects on investment levels, has a totally different impact on the propensity to investment. The canonical investment theory under uncertainty, with

Balance-sheet Strength (Net Leverage)

non-convex adjustment costs to capital like fixed costs or irreversibility, implies that firms should be more cautious in making investment decisions during high-uncertainty periods.

Bloom (2007), Dixit and Pindyck (1994), and Magud (2008) point out that ‘caution’ means a more limited response of investment to changes in the external environment given that firms have the option of waiting until uncertainty decreases to move on with capital expenditures.

Thus, firms have a lower marginal propensity to invest—i.e., holding constant the level of financial imperfections, firms are more reluctant to invest out of any extra dollar from cash flows. We dub this channel the wait-and-see or real-options channel.

Figure 3. Marginal propensity to invest and transmission channels

Notes: The left panel illustrates the average response of corporate investment to higher uncertainty or interest rates in the presence of financial frictions where the slope represents the marginal propensity to invest out of cash flows (MPI). The right panel illustrates the two channels at work: under the financing channel MPI increases (after higher uncertainty or interest rates) whereas under the wait-and-see channel (after uncertainty shocks), MPI decreases.

To support the statements above, we present both simple OLS and Nadaraya-Watson non-parametric fittings of investment on (lagged) net leverage during high vs. low uncertainty periods to illustrate graphically the role of heterogeneity in shaping the response of firm-level investment to changes in uncertainty. As Figure 4 shows, firms with higher net leverage reduce investment more than firms with lower net leverage when uncertainty increases.10

10 Here high vs. low means whether in a particular year the VIX is above or below the median.

Cash Flows

Investment

1 Extra Dollar

Inv. Increment (MPI)

Level Shift

Cash Flows

Investment

Slope Before Shock

Wait-n-See Channel Financing Channel

1 Extra Dollar

Inv. Increment (MPI)

Figure 4. Heterogeneous responses upon uncertainty shocks

Notes: The left panel shows the uni-variate fitting of the investment ratio to (lagged) net leverage for periods of low (upper line) and high (lower line) volatility, respectively. We define low vs. high by whether the VIX is below or above the median.

We observe that when uncertainty switches from low to high, the fitting line not only shifts downward but also rotates, becoming steeper, indicating that firms with weaker balance sheets cut investment more aggressively. Similar results are shown in the right panel, where we adopt the standard Nadaraya-Watson kernel fitting to incorporate possible nonlinearities (bands are 95-percent confident intervals).

We explore these channels more formally in the empirical framework discussed next.

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